S Corporation Tax Trap

Be aware of this trap that snares some owners of S corps.
S corps must pay a penalty tax when they draw out more than their investment.
That happens when liabilities exceed assets.
We are suddenly running into this circumstance …

Be aware of why it happens and how you can avoid it.

If you’re interested in S corps as a topic all to themselves, please read the entire post. If you’re as nerdy as me, you can’t resist this.  If you just want to find out about the penalty tax … page down to “penalty tax”.

S corps are tax shelters. 

The only better tax shelter on the face of the earth is a cash flow business. (We’ll save this for another time.) But when you take a cash flow business and turn it into an S corp, that’s tax shelter on steroids.  Which is why we love the combination.

The only businesses that don’t elect to be S corps are those who don’t qualify … or those who happen to be complete idiots about this kind of thing, or their tax advisors are.  Coors was an S corp until they exceeded the number of shareholders allowed. Gallo Wines is still an S corp, but only because they have lobbied Congress, so we have heard (i.e., lavished them with free wine and money).  S corps used to be limited to 10 shareholders. But at the urging of Gallo (so I have heard), the limit increased to 100. Then the limit was increased again, at the urging of the Gallo family so I have heard, by changing the definition of shareholder.

They wouldn’t go to that much trouble if the savings weren’t significant.

Tax savings can be significant.

An S corp offers the tax protection just discussed along with the liability protection afforded by the corporate form with liability protection came into being in the year 565 under the emperor Justinian of Rome (so says Wikipedia).  We are more interested in the English version because U.S. law is based on English common law. That stretches back to 1600 when the British East India company was incorporated. So the corporate form has a long and storied history of 1500 years if you go all the way back to Rome … or 400 years under common law. LLCs (Limited Liability Companies) on the other hand have been around for less than 25 years. In comparison, legal precedent of limited liability companies with nearly 25 years of history is barely getting established. Some lawyers actually specialize on “piercing the veil” of LLCs. If you want to know how to do that, give me a call. It is possible to pierce basically any LLC.

We love S corps and recommend them widely.

However, there are some issues with S corps that need close attention.

The IRS hates S corps.  For decades the IRS have been attempting to get rid of them (or alter their taxation).  Only equity bankers and trial lawyers have kept that from happening.  Follow the money. Do the math. Whatever … Thank you “equity bankers” and “trial lawyers.” Those two groups profit most from S corps and also contribute more money to Congress than any other groups.  Congress isn’t willing to alienate their largest contributors. S corps even escaped the 3.86% Obamacare surtax.

Since the IRS can’t get rid of S corps, they have taken the approach of surrounding them with rules and regulations instead. These aren’t in the tax code per se, except by interpretation, but are IRS inventions to harass and irritate owners of S corps.  One of these is the requirement for a reasonable salary, which, if you have an S corp with us, you’ve heard about time and time again.

This is another one of those things that can sting you … The upside down penalty tax on S corps owners … so named by us.

Penalty Tax

This is a particularly heinous issue that can sneak up on you when you’re least expecting it.  One of the primary benefits of S corps is that  corporate earnings are not subject to double taxation in the way a C corp is.  The reasoning behind the tax is this … you are taxed when you take more out of an S corp than you have invested in that S corp. These are taxed at capital gains rates. This is in addition to earnings, which are also taxed, but at ordinary income rates.  if an S corp gets upside down (more liabilities than assets), then then the owner will be taxed on the amount it is upside down … at capital gains rates.

An S corp, or any business actually, becomes upside down when liabilities exceed assets.  That can only happen when you take out more money to drop your cash balance below the amount necessary to repay the debt. Debt (liabilities) can be credit cards, an SBA loan or any other loan.  Other liabilities can be recognized if inventory is a significant factor in your earnings because you are required to file on “accrual basis” instead of “cash basis”. That causes the recognition of unpaid trade payables as liabilities.

In the past we had a client who created an S corp, took out a bank loan in his S corp. then transferred the money to his personal account to put in a swimming pool.  As a matter of fact, we have seen this kind of thing repeatedly. Bingo, bango, bongo. You’re suddenly upside down facing a penalty tax. This particular client had completely missed it and left if off their tax return for two years … And in the meantime the IRS had started tracking that kind of thing so it was only a matter of time.

That’s always a lot of fun … “Hey, you thought you didn’t owe any tax.  Guess what? You actually owe $57,000.”  As a client, you know how much a client loves to hear that.   “And on top of that, you have to amend your last two tax returns and pay another $40,000.”

We also have clients who carry balances on company credit cards and take out all their profits. We recommend that you take excess profits out annually at the beginning of the year, or quarterly at the beginning of the month.

Now you’ll know what we’re talking about if we have to tell you this happened to you  …